As the market starts to wobble after its huge rally over the past six months, investors will once again turn to leveraged and inverse ETFs to try to protect their gains. Although these high-powered ETFs are best suited to those who measure their investing results over the course of days rather than years, even long-term investors can get something out of keeping their eyes on them.
The beauty of leveraged ETFs
When leveraged ETFs first came out several years ago, they seemed to give investors something they'd always dreamed of. At first glance, the ETFs appeared to offer multiplied returns on the indexes they tracked. So if you thought the market was going to rise 10%, the theory went, you should be able to buy a double-leveraged ETF and make 20%.
In addition, leveraged funds came in both bullish and bearish flavors. Inverse leveraged funds were especially attractive to many traders because they offered a way to bet on a market decline even within accounts where true short-selling wasn't typically available, such as retirement accounts. So again, if you thought the market would drop 10%, the hope was you could use a double-inverse ETF to score a 20% profit.
After a somewhat slow start, leveraged ETFs became very popular, especially during turbulent periods for the market such as late 2008 and early 2009. Average volumes for ProShares Ultra S&P 500 (NYSE: SSO ) rose from less than 70,000 shares daily in September 2006 to more than 110 million shares at the market's bottom in 2009. The bearish ProShares UltraShort S&P 500 (NYSE: SDS ) saw a similar jump in popularity, with volume rising from around 200,000 shares daily at the fund's 2006 introduction to more than 70 million in November 2008 and May 2010. The rise in sector-specific leveraged ETFs was even more dramatic; ProShares UltraShort Financial (NYSE: SKF ) , for instance, blossomed from just a few thousand shares daily to more than 10 million as investors raced to bet against financials in the midst of the biggest bank crisis since the Great Depression.
Fact vs. fiction
Unfortunately, investors who used leveraged ETFs for longer-term investing didn't understand the impact of the method those ETFs used to leverage their returns. In particular, because most leveraged ETFs target daily returns, the natural rising and falling oscillations in the market caused their value to erode over time.
Short-term investors didn't have to worry about those effects, but when you look at long-term results, you can see the big hit that some confused investors took on leveraged ETFs. For instance, during the past three years, the ProShares UltraShort Oil & Gas ETF (NYSE: DUG ) lost more than 41% annually, as the prices of energy stocks have generally gone up. But surprisingly, shares of the corresponding bullish ProShares Ultra Oil & Gas ETF (NYSE: DIG ) didn't produce similar gains. Instead, they've dropped at a 14% annual pace since early 2008. You can see the same phenomenon with financial stocks; the triple-leveraged bearish financial ETF Direxion 3x Daily Financial Bear (NYSE: FAZ ) has lost 34% over the past year as many financials rallied, but the Direxion 3x Daily Financial Bull (NYSE: FAS ) has dropped 14%.
So why bother looking?
If these ETFs have done such a bad job of taking away long-term investors' money, then why should you bother putting them on your watchlist? The simple answer is that these ETFs give you a window into the behavior of a much different group of market participants than you're familiar with as a long-term investor.
It's always interesting to see how short-term traders are thinking about a particular stock. By using their tunnel-vision approach against them, you can follow their trends and turn them to your advantage, taking the opportunity to buy promising shares when they're cheap or to sell overpriced stocks before a correction takes away your gains.
Moreover, if you put inverse funds on your watchlist, you'll get to read some bearish commentary to give you the other side of a particular trade. Even if you're convinced that the bullish case is the smarter play, it's valuable to give yourself a gut check from time to time.
So as we wait to see if this brief downturn becomes an official correction -- or something more ominous -- put some leveraged ETFs on your watchlist. You may not want them in your portfolio, but keeping them on the radar will give you valuable insight into how other investors are dealing with the current market environment.
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